Macroeconomic Theory

Labor Supply 70 4.7 Firms 73 4.7.1 Labor Demand without Adjustment Costs 73 4.7.2 Labor Demand with Adjustment Costs 75 4.8 General Equilibrium in a Decentralized Economy 77 4.8.1 Consolidating the Household and Firm Budget Constraints 77 4.8.2 The Labor Market 79 4.8.3 The Goods Market 80 4.9 Comparison with the Centralized Model 81 4.10 Conclusions 83 Chapter 5: Government: Expenditures and Public Finances 84 5.1 Introduction 84 5.2 The Government Budget Constraint 86 5.2.1 The Nominal Government Budget Constraint 86 5.2.2 The Real Government Budget Constraint 88 5.2.3 An Alternative Representation of the GBC 88 5.3 Financing Government Expenditures 89 5.3.1 Tax Finance 89 5.3.2 Bond Finance 91 5.3.3 Intertemporal Fiscal Policy 93 5.3.4 The Ricardian Equivalence Theorem 93 5.4 The Sustainability of the Fiscal Stance 96 5.4.1 Case 1 (Stable Case) 98 5.4.2 Implications 99 5.4.3 Case 2: (Unstable Case) 100 5.4.4 Implications 101 5.4.5 The Optimal Level of Debt 102 5.5 The Stability and Growth Pact 103 5.6 The Fiscal Theory of the Price Level 104 5.7 Optimizing Public Finances 105 5.7.1 Optimal Government Expenditures 106 5.7.2 Optimal Tax Rates 109 5.8 Conclusions 119 Chapter 6: Fiscal Policy: Further Issues 121 6.1 Introduction 121 6.2 Time-Consistent and Time-Inconsistent Fiscal Policy 121 6.2.1 Lump-Sum Taxation 123 6.2.2 Taxes on Labor and Capital 126 6.2.3 Conclusions 131 6.3 The Overlapping-Generations Model 131 6.3.1 Introduction 131 6.3.2 The Basic Overlapping-Generations Model 132 6.3.3 Short-Run Dynamics and Long-Run Equilibrium 135 6.3.4 Comparison with the Representative-Agent Model 137 6.3.5 Fiscal Policy in the OLG Model: Pensions 138 6.3.6 Conclusions 143 Chapter 7: The Open Economy 144 7.1 Introduction 144 7.2 The Optimal Solution for the Open Economy 145 7.2.1 The Open Economy's Resource Constraint 145 7.2.2 The Optimal Solution 148 7.2.3 Interpretation of the Solution 149 7.2.4 Long-Run Equilibrium 150 7.2.5 Shocks to the Current Account 152 7.3 Traded and Nontraded Goods 154 7.3.1 The Long-Run Solution 158 7.4 The Terms of Trade and the Real Exchange Rate 159 7.4.1 The Law of One Price 160 7.4.2 Purchasing Power Parity 160 7.4.3 Some Stylized Facts about the Terms of Trade and the Real Exchange Rate 161 7.5 Imperfect Substitutability of Tradeables 163 7.5.1 Pricing-to-Market, Local-Currency Pricing, and Producer-Currency Pricing 163 7.5.2 Imperfect Substitutability of Tradeables and Nontradeables 163 7.6 Current-Account Sustainability 167 7.6.1 Balance of Payments Sustainability 167 7.6.2 The Intertemporal Approach to the Current Account 173 7.7 Conclusions 174 Chapter 8: The Monetary Economy 176 8.1 Introduction 176 8.2 A Brief History of Money and Its Role 176 8.3 Nominal Household Budget Constraint 179 8.4 The Cash-in-Advance Model of Money Demand 181 8.5 Money in the Utility Function 183 8.6 Money as an Intermediate Good or the Shopping-Time Model 185 8.7 Transactions Costs 188 8.8 Some Empirical Evidence 190 8.9 Hyperinflation and Cagan's Money-Demand Model 192 8.10 The Optimal Rate of Inflation 194 8.10.1 The Friedman Rule 194 8.10.2 General Equilibrium Solution 195 8.11 The Super-Neutrality of Money 199 8.12 Conclusions 201 Chapter 9: Imperfectly Flexible Prices 203 9.1 Introduction 203 9.2 Some Stylized "Facts" about Prices and Wages 204 9.3 Price Setting under Imperfect Competition 206 9.3.1 Theory of Pricing in Imperfect Competition 207 9.3.2 Price Determination in the Macroeconomy with Imperfect Competition 209 9.3.3 Pricing with Intermediate Goods 213 9.3.4 Pricing in the Open Economy: Local and Producer-Currency Pricing 216 9.4 Price Stickiness 217 9.4.1 Taylor Model of Overlapping Contracts 218 9.4.2 The Calvo Model of Staggered Price Adjustment 219 9.4.3 Optimal Dynamic Adjustment 221 9.4.4 Price Level Dynamics 222 9.5 The New Keynesian Phillips Curve 224 9.5.1 The New Keynesian Phillips Curve in an Open Economy 227 9.6 Conclusions 228 Chapter 10: Asset Pricing and Macroeconomics 230 10.1 Introduction 230 10.2 Expected Utility and Risk 231 10.2.1 Risk Aversion 231 10.2.2 Risk Premium 232 10.3 No-Arbitrage and Market Efficiency 233 10.3.1 Arbitrage and No-Arbitrage 233 10.3.2 Market Efficiency 233 10.4 Asset Pricing and Contingent Claims 234 10.4.1 A Contingent Claim 234 10.4.2 The Price of an Asset 235 10.4.3 The Stochastic Discount-Factor Approach to Asset Pricing 235 10.4.4 Asset Returns 235 10.4.5 Risk-Free Return 236 10.4.6 The No-Arbitrage Relation 236 10.4.7 Risk-Neutral Valuation 237 10.5 General Equilibrium Asset Pricing 238 10.5.1 Using Contingent-Claims Analysis 238 10.5.2 Asset Pricing Using the Consumption-Based Capital Asset-Pricing Model (C-CAPM) 240 10.6 Asset Allocation 247 10.6.1 The Capital Asset-Pricing Model (CAPM) 250 10.7 Consumption under Uncertainty 251 10.8 Complete Markets 252 10.8.1 Risk Sharing and Complete Markets 253 10.8.2 Market Incompleteness 256 10.9 Conclusions 256 Chapter 11: Financial Markets 258 11.1 Introduction 258 11.2 The Stock Market 259 11.2.1 The Present-Value Model 259 11.2.2 The General Equilibrium Model of Stock Prices 262 11.2.3 Comment 265 11.3 The Bond Market 265 11.3.1 The Term Structure of Interest Rates 266 11.3.2 The Term Premium 272 11.3.3 Estimating Future Inflation from the Yield Curve 277 11.3.4 Comment 279 11.4 The FOREX Market 279 11.4.1 Uncovered and Covered Interest Parity 280 11.4.2 The General Equilibrium Model of FOREX 289 11.4.3 Comment 292 11.5 Conclusions 293 Chapter 12: Nominal Exchange Rates 295 12.1 Introduction 295 12.2 International Monetary Arrangements 1873-2007 297 12.2.1 The Gold Standard System: 1873-1937 298 12.2.2 The Bretton Woods System: 1945-71 299 12.2.3 Floating Exchange Rates: 1973-2007 300 12.3 The Keynesian IS-LM-BP Model of the Exchange Rate 304 12.3.1 The IS-LM Model 305 12.3.2 The BP Equation 309 12.3.3 Fixed Exchange Rates: The Monetary Approach to the Balance of Payments 312 12.3.4 Exchange-Rate Determination with Imperfect Capital Substitutability 313 12.4 UIP and Exchange-Rate Determination 315 12.5 The Mundell-Fleming Model of the Exchange Rate 317 12.5.1 Theory 317 12.5.2 Monetary Policy 318 12.5.3 Fiscal Policy 319 12.6 The Monetary Model of the Exchange Rate 320 12.6.1 Theory 320 12.6.2 Monetary Policy 321 12.6.3 Fiscal Policy 325 12.7 The Dornbusch Model of the Exchange Rate 325 12.7.1 Theory 325 12.7.2 Monetary Policy 328 12.7.3 Fiscal Policy 330 12.7.4 Comparison of the Dornbusch and Monetary Models 330 12.8 The Monetary Model with Sticky Prices 332 12.9 The Obstfeld-Rogoff Redux Model 334 12.9.1 The Basic Redux Model with Flexible Prices 335 12.9.2 Log-Linear Approximation 341 12.9.3 The Small-Economy Version of the Redux Model with Sticky Prices 343 12.10 Conclusions 346 Chapter 13: Monetary Policy 348 13.1 Introduction 348 13.2 Inflation and the Fisher Equation 353 13.3 The Keynesian Model of Inflation 355 13.3.1 Theory 355 13.3.2 Empirical Evidence 358 13.4 The New Keynesian Model of Inflation 358 13.4.1 Theory 358 13.4.2 The Effectiveness of Inflation Targeting in the New Keynesian Model 365 13.4.3 Inflation Targeting with a Flexible Exchange Rate 369 13.5 Optimal Inflation Targeting 371 13.5.1 Social Welfare and the Inflation Objective Function 372 13.5.2 Optimal Inflation Policy under Discretion 374 13.5.3 Optimal Inflation Policy under Commitment to a Rule 378 13.5.4 Intertemporal Optimization and Time-Consistent Inflation Targeting 380 13.5.5 Central Bank versus Public Preferences 382 13.6 Optimal Monetary Policy using the New Keynesian Model 384 13.6.1 Using Discretion 384 13.6.2 Rules-Based Policy 386 13.7 Monetary Policy in the Euro Area 387 13.7.1 New Keynesian Model of the Euro Area 389 13.7.2 Model 389 13.7.3 Optimal Monetary Policy 390 13.7.4 Competitiveness and Absorbtion 392 13.7.5 Is There Another Solution? 393 13.8 Conclusions 393 Chapter 14: Real Business Cycles, DGE Models, and Economic Fluctuations 396 14.1 Introduction 396 14.2 The Methodology of RBC Analysis 397 14.2.1 Steady-State Solution 400 14.2.2 Short-Run Dynamics 401 14.3 Empirical Evidence on the RBC Model 405 14.3.1 The Basic RBC Model 406 14.3.2 Extensions to the Basic RBC Model 408 14.3.3 The Open-Economy RBC Model 410 14.4 DGE Models of the Monetary Economy 415 14.4.1 The Smets-Wouters Model 416 14.4.2 Empirical Results 420 14.5 Conclusions 422 Chapter 15: Mathematical Appendix 424 15.1 Introduction 424 15.2 Dynamic Optimization 424 15.3 The Method of Lagrange Multipliers 426 15.3.1 Equality Constraints 426 15.3.2 Inequality Constraints 431 15.4 Continuous-Time Optimization 432 15.4.1 Calculus of Variations 433 15.4.2 The Maximum Principle 434 15.5 Dynamic Programming 434 15.6 Stochastic Dynamic Optimization 438 15.7 Time Consistency and Time Inconsistency 440 15.8 The Linear Rational-Expectations Models 442 15.8.1 Rational Expectations 443 15.8.2 The First-Order Nonstochastic Equation 444 15.8.3 Whiteman's Solution Method for Linear Rational-Expectations Models 446 15.8.4 Systems of Rational-Expectations Equations 453 References 459 Index 471